Jetlag has me up and at the keyboard at 5.54am here in London, 43 minutes before sunrise, which today is at 6.37am.

Only it’s not “sunrise”, is it? As we all know, it’s really “Earth Axial Rotate” at the point in its 24 hour axial rotation when the Sun—around which the Earth rotates once each year—becomes visible from London.

We still call it “sunrise” because it’s a lot less awkward—and a lot more romantic—than saying “Earth Axial Rotate Earth-Sun Radial Alignment”, which is what it really is. We all know that it’s not really the Sun “rising” at all: that implies that the Earth is fixed while the Sun rotates around it, whereas ever since Copernicus we have known that, though it looks that way to a naïve observer on Earth, that’s not what really happens.

However, not merely before Copernicus, but for a very long time after him, many people continued to believe that that was how it really is: that the Sun does rotate around the Earth, that the Earth is not merely fixed, but fixed at the Centre of the Universe, and not merely the Sun but all Celestial bodies rotate around it in perfect spheres.

What broke us from that belief was the empirical failure of the theory which encapsulated it and still made sense—as much as it could—of the anomalies between the predictions of that theory, and actual reality. Claudius Ptolemy‘s treatise the “Mathematike Syntaxis” (or Mathematical Composition), which became known as the Almagest (meaning “The Great Treatise”), was published in about 150 BC, and it provided a plausible model for earth-centric beliefs about the nature of the Universe that dated back millennia. It held sway not merely until Copernicus wrote his De revolutionibus orbium coelestium in 1543, but for many decades after, as not only the Church but also incensed Ptolemaic astronomers fought to suppress the new, more accurate, but to them heretical and false model of the Universe.

Why the brief discourse on Astronomy? Because reading what Paul Krugman is saying about banking feels like reading a Ptolemaic Astronomer describing sunrise today as if that’s actually what’s happening. He is dismissive of the view that banks can “create credit out of thin air”—so dismissive in fact, that anyone unacquainted with the empirical evidence might be fooled into believing that his case is so strongly supported by the facts that it’s not even worth the bother of citing the empirical data that backs it up.

That is so NOT the case: the empirical evidence overwhelmingly supports the case Krugman is trying to dismiss out of hand, that banks can and do “create credit out of thin air”, with the supposed regulatory controls over their capacity to do so being largely ineffective.

Figure 1: Krugman’s 3rd post on banking and money creation

In fact the evidence is so strongly in favour of the case that Krugman blithely dismisses that it’s difficult to decide where to begin in refuting his Ptolemaic fantasies to the contrary. I’ll lead with his “gotcha!” argument in this post, but before that I’ll return to the Ptolemaic Astronomy-Neoclassical Economics analogy—because it’s quite a strong one that deserves further elucidation.

Ptolemy and Walras—Brothers in Arcs

The Geocentric models of the universe, of which Ptolemy’s system was a variation, had 3 guiding principles, which Cardall describes as follows:

All motion in the heavens is uniform circular motion.

The objects in the heavens are made from perfect material, and cannot change their intrinsic properties (e.g., their brightness).

The key problem with this base theory is that it manifestly didn’t fit the facts, because of the behaviour of celestial bodies that we now call Planets—which is the ancient Greek word for “wanderers”. Far from obeying uniform circular motion, these Wanderers literally did wander all over the sky. We’re generally not aware of this today because it’s no big deal from our better-informed Heliocentric model of the solar system, but for the ancients it was a big deal. A simulation by David Colarusso indicates how much the apparent behaviour of the Wanderers violated the three core tenets of the Geocentric model.

Ptolemy’s contribution was to provide “tweaks” to this core vision, which maintained its overall integrity while fitting it much more closely to the data. He stuck with most of proposition (1) and all of (2), but modified (3) to “The Earth is near the center of the Universe”. With the Earth slightly off-center, the generally elliptical motion of The Wanderers could now be explained by what was called The Eccentric. But their habit of “retrograde” motion—the fact that they would occasionally reverse direction in the night sky—was still an anomaly.

To solve that, Ptolemy added circular motion on circular motion. All celestial bodies still followed a great circle—called the Deferent—but the planets also did their own rotations on the Deferent on mini-circles called Epicycles.

But even that wasn’t enough, because the planets also appeared to speed up on part of their motion through the heavens, and slow down on others (today we know this is just because sometimes they are closer to the earth on their elliptical orbits around the earth, and therefore appear to move more rapidly). So Ptolemy added “Equant” motion: the big “Deferent” circle each planet moved on was divided into segments by lines through a point which was not its center, and the planet moved through each differently sized slice in the same time—thus speeding up in the big slices and slowing down in the small ones.

By these tweaks, a paradigm which was utterly unlike the real world was actually able to mimic it to a tolerable level of accuracy. But the system was extremely complicated, and it took an enormous amount of brain power to be a Ptolemaic astronomer. Looking back on this once dominant theory, Cardall tellingly observes how the very complexity of this absolutely false mental construct helped preserve it despite mounting evidence that it did not describe reality:

That ancient astronomers could convince themselves that this elaborate scheme still corresponded to “uniform circular motion” is testament to the power of three ideas that we now know to be completely wrong, but that were so ingrained in the astronomers of an earlier age that they were essentially never questioned. (Cardall, 2000)

Why am I reminded of Neoclassical Economics? Let me count the ways…

Firstly, there are similar underlying principles to the DSGE models that now dominate Neoclassical macroeconomics, and as with Ptolemaic Astronomy, these underlying principles clearly fail to describe the real world. They are:

All markets are barter systems which are in equilibrium at all times in the absence of exogenous shocks—even during recessions—and after a shock they will rapidly return to equilibrium via instantaneous adjustments to relative prices;

The preferences of consumers and the technology employed by firms are the “deep parameters” of the economy, which are unaltered by any policies set by economic policy makers; and

Perfect competition is universal, ensuring that the equilibrium described in (1) is socially optimal.

If that were actually the real world, then not only would there not be a crisis now, there would never have been a Great Depression either—and recessions would simply be minor statistically unpredictable but inevitable events when the majority of shocks hitting the economy were negative, and they would rapidly be resolved by adjustments to relative prices (wages included, of course).

So economists like Krugman—who describe themselves as “New Keynesians”—have tweaked the base case to derive models that “ape” real-world data, with “sticky” prices rather than perfectly flexible ones, “frictions” that slow down quantity adjustments, and imperfect competition to generate less-than-optimal social outcomes.

This is Ptolemaic Economics: take a model that is utterly unlike the real world, and which in its pure form can’t possibly fit real world data, and then add “imperfections” so that it can appear to do so.

Figure 2: Krugman’s 3rd post on banking and money creation

Walk like a Ptolemain

Krugman’s rejection of the proposition that banks can create money—in the sense that “their ability to create money is not constrained by the monetary base” as he puts it in an update—is also a vintage Ptolemain manoeuvre. A scientific response to this proposition would be to disprove it via empirical evidence. Krugman instead appeals to his own authority, relies on deductive logic—which I’ll return to shortly—and derides those who believe that banks and credit growth matter in macroeconomics as “Banking Mystics”.

What Krugman displays here is not greater insight but blind ignorance. A recent addition to the overwhelming evidence that credit growth is a crucial factor in macroeconomics is an empirical paper by those well-known bastions of Banking Mysticism, the National Bureau of Economic Research and the Federal Reserve Bank of San Francisco. The paper analyses 200 recessions in 14 countries over 140 years, and summarises its results as follows:

This paper studies the role of leverage in the business cycle. Based on a study of nearly 200 recession episodes in 14 advanced countries between 1870 and 2008, we document a new stylized fact of the modern business cycle: more credit-intensive booms tend to be followed by deeper recessions and slower recoveries. We find a close relationship between the rate of credit growth relative to GDP in the expansion phase and the severity of the subsequent recession. We use local projection methods to study how leverage impacts the behavior of key macroeconomic variables such as investment, ending, interest rates, and inflation. The effects of leverage are particularly pronounced in recessions that coincide with financial crises, but are also distinctly present in normal cycles. The stylized facts we uncover lend support to the idea that financial factors play an important role in the modern business cycle. (Oscar Jorda et al., 2011a, Oscar Jorda et al., 2011b)

That emphatically decides the key empirical dispute—whether the level and rate of growth of aggregate private debt has macroeconomic effects—in favour of the case I put.

Unreserved Lending

There is also a wealth of studies to support the contention that reserves don’t constrain lending—that if anything, the causal link runs from lending to reserves, and not the other way around. I referred to some of these in my last blog post, so I won’t repeat that issue here. Instead I’ll take up Paul’s “gotcha” argument to the contrary:

Yes, a loan normally gets deposited in another bank — but the recipient of the loan can and sometimes does quickly withdraw the funds, not as a check, but in currency. And currency is in limited supply — with the limit set by Fed decisions. So there is in fact no automatic process by which an increase in bank loans produces a sufficient rise in deposits to back those loans, and a key limiting factor in the size of bank balance sheets is the amount of monetary base the Fed creates — even if banks hold no reserves.

Sigh. The level of currency retrains lending? So banks stop lending as they approach the limits to currency set by the Fed’s printing of notes?

I can’t improve on the comments of Neil Wilson on Krugman’s argument here:

Krugman needs to start attending the real world. The latest argument is utter tosh. For there to be a constraint in the real world, you have to have the actual power to stop another entity from doing something.

What Krugman is suggesting is that the Fed has the power to limit the amount of currency in issue. In other words he’s suggest that to control the economy the ATMs will be left to run dry and you will be told ‘no’ when you go and try and draw cash at the bank counter.

Sweepstake on how many attoseconds it would take to cause general pandemonium if that every happened. Here in the UK there has been a suggestion that the fuel pumps might be short of fuel if the tanker drivers did decide to go on strike. It has caused complete chaos even though nothing is different this weekend than last. Krugman is beyond grasping at straws now.

And even if the Fed could do that—even if it did attempt to control bank lending by manipulating reserves (something it gave up on doing about 30 years ago)—there are two factors needed to make manipulating reserves a control mechanism over bank lending:

Reserves themselves; and

A mandated ratio between deposits at banks and reserves

Paul doesn’t seem to have caught up with the fact that this mandated ratio no longer exists, for all practical purposes, in the USA and much of the rest of the OECD. Six countries have no reserve requirements whatsoever; the USA still has one, but for household deposits only. Figure 3 shows the actual rules for reserves in the USA—taken from an OECD paper in 2007 (Yueh-Yun June C. O’Brien, 2007). The reserve ratio of 10% only applies to household deposits; corporate deposits have no reserve requirement. And the reserves are required with a 30 day lag after lending has occurred—by which time the deposits created by the lending are percolating through the banking system.

Figure 3: USA Reserve Requirements

This, and the banking crisis we are now in, finally inspired the Federal Reserve’s research department to conclude that, effectively, the “money multiplier” doesn’t exist. Carpenter and Demiralp note that today reserve requirements “are assessed on only about one-tenth of M2“, and conclude that

So Paul’s “gotcha” lacks at least one of the blades needed to make it work—and if he cares to consult the extensive academic literature on the role of reserves post the failed Monetarist experiment of the 1970s, he will see that the other blade doesn’t exist either: Central Banks now supply whatever level of reserves is needed to maintain their short-run interest rate target.

Who’s the Mystic then?

Krugman’s claim that those who argue banks play an essential role in macroeconomics are “Banking Mystics” has a natural riposte: Neoclassical economists like Krugman who believe that capitalism can be modelled without either money or banks are Barter Mystics (David Graeber, 2011). How on earth can someone believe that the manifest reality that transactions involve money being exchanged for goods can be ignored, and pretend instead that goods are exchanged for goods? How on earth can the institutional reality of banks be ignored by those who claim to be macroeconomists?

How on earth indeed. It’s because they’re still living in a pre-Copernican universe, deluded by the imagined perfection of the Spheres.

Steve Keen is Professor of Economics & Finance at the University of Western Sydney with over 60 academic publications, and author of the popular book ,a href="http://www.amazon.com/Debunking-Economics-Revised-Expanded-Dethroned/dp/1848139926">Debunking Economics. Steve predicted the financial crisis as long ago as December 2005, and warned that back in 1995 that a period of apparent stability could merely be “the calm before the storm”. His leading role as one of the tiny minority of economists to both foresee the crisis and warn of it was recognised by his peers when he received the Revere Award from the Real World Economics Review for being the economist who most cogently warned of the crisis, and whose work is most likely to prevent future crises. Follow Steve on his blog or Twitter.

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32 Comments

“There is also a wealth of studies to support the contention that reserves don’t constrain lending—that if anything, the causal link runs from lending to reserves, and not the other way around”

In 1965 that “link” was referred to as the “Federal Funds Bracket Racket”. But your quip is a simplification (& only partially true) — until the FED introduced their new policy instrument: the payment of interest on reserve balances (put into play on Oct 3, 2008).

Just as an increase in currency held by the non-bank public is contractionary, so is an increase in the volume of excess reserve balances (other things being equal).

In their present state, IOeRs are a credit control device. IOeRs absorb bank deposits (which offset the expansion of the FED’s liquidity funding facilities on the asset side of its balance sheet, as well as QE1’s & QE2’s MBS, & Treasury purchases). Or in effect, IOeRs sterilize, for example, open market operations of the buying type.

By increasing the volume of un-used excess reserves outstanding (the ratio of reserves to deposits), the BOG absorbs, or reduces, the CB system’s lending capacity(either by siphoning the liquidity out of, or limiting the rate of expansion of, the fractional reserve banking system).

That’s exactly like raising reserve ratios, or traditionally “tightening” monetary policy. Raising the remuneration rate & therefore the volume of excess reserves held by the member banks is undeniably contractionary (& not inflationary).

In some respects neoclassical economics could be compared to Newtonian physics in a world dominated by the physics of Einstein. As many will be aware Newtonian physics works up to a point then it fails completely. General relativity covers far more of the real world than Newton, yet in our economic world the Einstein equivalent is ignored because it is Keynesian, and our policy makers live by Newtonian (neoclassical) models.

I was not being dismissive of Newtonian physics. In fact the Apollo moon program used nothing more than Newtonian physics to get there and back. Newtonian physics works for most physicists. Though my point was that once economies get into extreme states such as excessive debt that we have now, then neoclassical models fail. If governments had run counter cyclical policy to avoid a huge debt build up then we could probably still use Neoclassical models.

What is worse is that they are churning out loads more ill educated “economists” who espouse the wrong the wrong theories at some press conference. Imagine if they did accept that they were wrong, then all their former students would be justified in having all their student debts written off.

Whenever people claim to me that banks are actually lending reserves, or even worry much about what fraction of their reserves are being ‘leveraged’ I have two words: credit cards. My credit limit is based on an assessment of the risk I might not pay my CC bills, not on the size of my savings or current account. And in fact it’s been shown many times that banks would rather I didn’t pay the whole thing off every month, but in small enough bits to attract interest. Such ‘loans’ also happen without any reference to bank reserves, but to my pre-set limit, and taken globally, at far too fast a rate for any bank to keep track of in terms of its relationship to any ‘reserves’.

This ties together two issues I tend to be fixated on:
We model time as a vector from past to future, but the logical explanation is that it’s the changing configuration of what is, that turns future into past. The earth doesn’t travel along some fourth dimension from yesterday to tomorrow. Tomorrow becomes yesterday because the earth rotates. When you really get into the mechanics of spacetime and all the postulates emerging from it, from blocktime and wormholes, to expanding space, it really does get bizarre. It is a rather brilliant correlation between distance and duration, but treating it as causation is a large leap into fantasy. One could as easily use ideal gas laws to argue temperature is another parameter of volume. Both time and temperature are effects of action; rate of change and level of activity. Gravity fields, acceleration, etc. affect the level of atomic activity, thus affecting the rate of change, which is why clock rates are relative to conditions.
The issue with notational money is that it is a contract, not a commodity. Since banks manage it, it is a commodity to them, much as legal contracts are a commodity to lawyers. So it is in the interest of banks to produce as much of this paper as possible, which they do by creating demand for it, ie. debt.
An essay I wrote, combining these subjects and several others:http://www.exterminatingangel.com/index.php?option=com_content&task=view&id=826&Itemid=662

This may be a naive question, but isn’t there a difference between saying that (i) reserve requirements serve as a binding constraint on bank lending and (ii) changes in the amount of reserves in circulation affect bank lending?

It seems that (ii) can be true even if (i) is not.

Just as banks would finance themselves with (some amount of) equity capital even in the absence of capital requirements, they will hold (some amount of) reserves even in the absence of binding reserve requirements. They will do this as an operational matter, irrespective of any legal mandate.

If so, then reserves can constrain lending, even if reserve *requirements* are non-binding or do not exist.

A philosophical note:
What you’re describing ,which is called “sozein ta phainomena”(saving the phaenomena,the appearances,id est postulating hypotheses however unreal or of unknown value, to accurately(as much as possible) describe and predict (astronomical in historical context) phaenomena), is not neccessarily bad;in fact it’s(according to many) a legit philosophy and way of doing scientific business.
Instrumentalism might be called a modern version of it.

What is though indeed bad is the “sozein ta phainomena” or the “instrumentalism” of the kind of Friedman where and when not only the phaenomena aren’t really being saved, but also the hypotheses(for example free perfect markets) end up being elevated to semireal status, end up being the prescribed deontically way to go…

The article would possibly induce me to read it if “Earth Axial Rotate Earth-Sun Radial Alignment” used English grammar instead of randomly associating diverse parts of speech. Let’s begin with “rotate”. “Rotate” is a verb. (There is a noun “rotation”, but it doesn’t appear here.) Is it possible to find a grammatical subject for this verb? As there is no first or second person here, it must be a plural verb; as singular it would be “rotates”. There is no plural in this phrase/clause/name. The consequence is that it makes no sense if read, as opposed to skimmed.

Empirical evidence in a finite dataset can accidentally prove positions which are not correct. Recognizing that the dataset for the proposition that banks can create unlimited funds irrespective of the money supply will most certainly be limited, it is critical that economists look to models that fit the facts for more than just the case of the proposition but are not inconsistent with realities or other working models which are better grounded in the data. I’m afraid that Professor Keen and his ilk are basing their own observations off of the limited data set – much like the observers of the sun travelling around the earth – without attention to the broughter universe – the economy does not revolve around the money supply. I am displeased that Professor Krugman has decided to discontinue this discussion – but perhaps that is because Professor Keen, jetlagged and tired, is so dismissive in his posts to not engender a true teachable moment. When did professors lose the ability to learn from each other?

I came across this blog post through the grapevine. I never read Krugman for reasons you eloquently outlined in the above blog post. I do read another blog that linked to Krugman’s recent response to this post of yours.

All I can say is, kudos. You managed to conclusively demonstrate major problems with the model and catch Krugman in one of his many acts of what at least appears to me to be dishonesty.

The whole idea of modelling social events is just ridiculous, which is Keen is trying to do. Can anyone predict what score I will get in my exams tomorrow based on every bits of information about me? I guess no!

I disagree vehemently. Your intervention here, if taken to a logical extreme, implies that economics as a profession can serve no predictive function. And this is a false notion. The economy certainly has social elements to it, yes but it’s not pre-dominated by them. Keen is not trying to model social events; he is trying to capture more of the fat tail that traditional models have been unsuccessful in doing.

And your suggestion that Keen is just trying to get more attention has no basis in fact. This whole affair began largely because Paul Krugman put it in a spotlight on his blog multiple times.

I saw a TV broadcast of Steve Keen’s reaction to this spat. I do agree with him that banks need to be included in any model. While one mans debt is another mans asset. That only works to a point. The economy is now past that point. Debts are unmanageable and so will ultimately not be repaid in full. That means some debts really should not be counted as assets, that means losses and that needs to be included. One of my concerns about economic models is that they are deliberately obtuse to confuse non economists.

Banks do make a fundamental difference to the
way an economy functions. When a loan is made from one person to another, you
may be able to argue that there is no net debt and that the quantity of money
hasn’t changed. That is because when the money is transferred from one person
to the other, the money balance of the creditor gets drawn down. Banks do not
suffer from this limitation. Credit extended by banks do not draw down the
account of any depositor. Thus bank credit creates money (M1). Bank lending
does not “net out.” The economy is left in a different state after
bank lending than before.

I don’t think your analogy is that far off, but if you want to really understand the source of his confusion, I suggest you read how Krugman himself describes his approach: http://web.mit.edu/krugman/www/dishpan.html (Skip down to “THE FALL AND RISE OF DEVELOPMENT ECONOMICS”)

His analogy is how European’s have draw the map of Africa. First, we got everything wrong, both the shape of the outline and the interior. Second, as we learned to draw the outside accurately, we stopped putting anything on the inside because we had a higher standard for accuracy. Finally, we explored the center and got most of it right.

For Krugman, Economics is currently at the second stage: we accurately have the broad outlines, but we need to fill in the why, how and what on the inside. The neoclassical model was right, more or less, and neo-Keysianism was about filling in some of the inner details about sticky prices.

You are trying to convince him that not only is he projecting a bunch of inner details that are not there, but that he has the entire “shape” of the outline incorrect. You are not going to succeed at convincing him to abandon that.

In fact, you are not going to convince most economists until you come up with a new model. Plenty of people pointed out how the Ptolemaic didn’t conform with reality, but no one accepted those criticisms until Copernicus put forth a new model, one that not only explained the flaws, but worked to explain most or ALL the empirical data we had. You need to redraw the coastline of Africa.

This may be frustrating, but it’s not wrong. No model will exactly match up with reality (or else it would be reality), so we need to make certain assumptions for them to be tractable. People like you, behavioral economists, and MMT are all doing valuable work, but it won’t be enough to just provide ad hoc models for each phenomena where reality turns from the classical assumptions.

Those three assumptions need to be replaced, and then that model needs to hold up fairly well, not just from the perspective of debt recessions, monetary policy, and banking, but for everything.

I don’t think your analogy is that far off, but if you want to really understand the source of his confusion, I suggest you read how Krugman himself describes his approach: http://web.mit.edu/krugman/www/dishpan.html (Skip down to “THE FALL AND RISE OF DEVELOPMENT ECONOMICS”)

His analogy is how European’s have draw the map of Africa. First, we got everything wrong, both the shape of the outline and the interior. Second, as we learned to draw the outside accurately, we stopped putting anything on the inside because we had a higher standard for accuracy. Finally, we explored the center and got most of it right.

For Krugman, Economics is currently at the second stage: we accurately have the broad outlines, but we need to fill in the why, how and what on the inside. The neoclassical model was right, more or less, and neo-Keysianism was about filling in some of the inner details about sticky prices.

You are trying to convince him that not only is he projecting a bunch of inner details that are not there, but that he has the entire “shape” of the outline incorrect. You are not going to succeed at convincing him to abandon that.

In fact, you are not going to convince most economists until you come up with a new model. Plenty of people pointed out how the Ptolemaic didn’t conform with reality, but no one accepted those criticisms until Copernicus put forth a new model, one that not only explained the flaws, but worked to explain most or ALL the empirical data we had. You need to redraw the coastline of Africa.

This may be frustrating, but it’s not wrong. No model will exactly match up with reality (or else it would be reality), so we need to make certain assumptions for them to be tractable. People like you, behavioral economists, and MMT are all doing valuable work, but it won’t be enough to just provide ad hoc models for each phenomena where reality turns from the classical assumptions.

Those three assumptions need to be replaced, and then that model needs to hold up fairly well, not just from the perspective of debt recessions, monetary policy, and banking, but for everything.

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